How to control hedge funds
The head of the FSA tells Stephen Fay that only concerted international regulation can rein in the Masters of the Universe
Sunday 18 October 1998
Mr Davies has flown to Sydney for a meeting of regulators from the world's financial markets, which begins tomorrow. Jostling for top place on the agenda is what to do about those vigorous engines for swelling personal wealth, which have had such a destabilising effect recently.
The reason why the hedge funds are now crucial became clear to me 10 days ago in New York, when I sat in front of a screen in a small hedge fund with a dealer friend. I watched mesmerised as the yen went haywire.
The yen gained 6.7 per cent against the US dollar that day. In the jargon, that was 11 standard deviation points, and my dealer friend quickly calculated that the odds against that happening are more than 10 million to one.
He explained that hedge fund managers had become utterly convinced that the yen only lost value against the dollar. Consequently, they were strong sellers. They had taken up huge short positions, and failed to take precautions against a move up. The simple reason the yen had gone mad in a way that was profoundly unhelpful to the Japanese recovery was a symptom of a new order in global finance. The powerful hedge funds had never bothered to hedge.
But prudence was never part of the vocabulary of most hedge funds, which were invented to make large returns on speculative investments. They are on Mr Davies' mind at the Sydney summit of regulators because of some spectacular losses. Consider:
George Soros, the Master of the Universe, lost $2bn (pounds 1.2bn) in Russia.
Tiger Management, run by Julian Robertson, a minor master, lost $2bn in a day when it was on the wrong side of the yen.
DE Shaw, the brainchild of a brilliant professor, borrowed $1.4bn from Bank of America, which confessed last week that it had feared losing the lot.
Everest Capital lost $1.3bn; mortgage bond specialists Ellington lost $1.5bn on bonds last week.
And the biggest loser of all is Long Term Capital Management (LTCM), whose capital was worth $4.8bn and is now worth $1.3bn - or nothing at all, as the case may be. You take your pick.
It certainly puts Nick Leeson's losses into perspective. And these are the cases we know about. Plenty of other hedge funds are keeping mum until they are obliged to report at the end of this year.
It sounds odd, but when Mr Davies flew to Sydney he was fairly confident that the regulators would take no immediate action to curb and control the hedge funds: "Proactive regulators can affect markets, but largely to make them worse," he says.
None the less, he is certain that the only way the funds can be regulated is by formal international agreements of a kind that do not exist. "The main lesson so far is that people are going to be extremely sceptical of having either lending exposure or having massive trades with institutions that aren't prepared to tell them anything about their balance sheet," says Mr Davies.
He must be right about that, right now. But banks and securities businesses like Barclays, UBS and Merrill Lynch had jumped on LTCM's careering bandwagon because they found the promise of quick, above-average returns irresistible. When we spoke last week, just before he flew off, I asked Mr Davies what had happened to human nature to persuade him that such recklessness will not recur when autumn 1998 is a fading memory.
"I can't be sure it won't happen again," he replied. "That's why we're exploring various regulatory responses about the treatment of exposure to hedge funds, and the disclosure requirements that should be expected of them by financial institutions and regulators."
Part of the problem is that hedge funds often started life to care for the fortune of an individual and his family. If the fund was successful, it grew by word of mouth in an atmosphere that encouraged secrecy. Regulators have always found them opaque, but the respectable banks and brokers that lent them such vast sums knew only a little more. This will be basis of the first move by Mr Davies and his colleagues: "If banks and securities houses are lending into a black hole, then we'll have to consider treating that separately.
This financial crisis is the FSA's first real test. Mr Davies and his colleagues have moved into temporary offices in Canary Wharf, but the style is already established. His desk is in an open-plan space, opposite Michael Foot, the chief bank regulator. Passing employees can interpret the expression on the boss's face as they walk by. This is transparency.
The organisation of crisis management is in place, with the Standing Committee on Financial Stability at the top of the pile. The committee's ostensible membership is Mr Davies himself, the Governor of the Bank and the Chancellor, but the real work is done by their shadows - Michael Foot, Steve Robson from the Treasury and David Clementi, the Deputy Governor of the Bank. They study the scenarios.
When specific action is required - when, for example, Barclays reveals a pounds 250m write-off in Russia and follows this up with a boob in LTCM - the job passes to the FSA's Complex Products Group, which supervises the 55 largest organisations in the UK markets, from NatWest to Goldman Sachs to the Halifax. This group is headed by Oliver Page, who came from the Bank, and draws together people who worked for the Bank and specialist regulators like the SIB and the SFA.
On issues like LTCM regulatory contact with colleagues in the US is "instantaneous", says Mr Davies. It was not always so, but he believes that hedge funds can only be regulated internationally. If standards are not uniform in all major markets, the funds will do business where regulation is least robust. This is regulatory arbitrage.
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